Financial world still amazed over Madoff's downfall

The financial world begins this week still in a daze over the spectacular collapse of an alleged Ponzi scheme by onetime Wall Street legend Bernard Madoff — possibly the biggest swindle ever committed by a single person.

It's "a stunning fraud that appears to be of epic proportions," Andrew Calamari of the Securities and Exchange Commission's New York Regional Office said in a statement after the FBI arrested Madoff last week.

It's unclear how many institutions and individuals will suffer from losses that federal authorities say Madoff privately pegged at $50 billion.

The repercussions could affect the entire investment industry if lawmakers decide they must try to prevent additional losses on such a massive scale. "It's a good thing, because cases like Madoff will lead to tighter and more oversight," says Roland Eberhard, who oversees $500 million in investments for Basel Asset Management.

Officials allege that Madoff falsified reports from a secretive money management service that he owned — run separately from his main stock transaction firm — to make it appear to be more successful than it was. Madoff allegedly kept it going by taking cash from unwitting new investors to pay customers who wanted to redeem their holdings.

In a January SEC filing, Madoff said he managed $17.1 billion in assets for 23 clients. But potential victims could number in the hundreds and possibly thousands and include major banks, hedge funds, charities and pension funds.

Responding to an SEC lawsuit, on Friday, U.S. District Judge Louis Stanton in New York froze the assets and accounts of Madoff's investment business and appointed Lee Richards, an attorney at Richards Kibbe & Orbe, as receiver.

Madoff's lawyers have denied the charges but did not return calls for comment. Madoff was released after posting $10 million in bail. He faces up to $5 million in fines and up to 20 years in jail if convicted. The SEC and U.S. Attorney's office say their investigation is continuing and declined to comment.

For now, many are amazed at the abrupt collapse of a financier considered so innovative and successful that wealthy individuals and blue-chip firms sought his investment services and advice.

A Hofstra Law School graduate who started his career with $5,000 saved working as a lifeguard, Madoff spent 48 years cultivating a reputation as a pioneer of electronic trading and the development of the Nasdaq Stock Market. He was its chairman in the early 1990s and served on the boards of the National Association of Securities Dealers and the Securities Industry Association. He's "considered a statesmen in our industry," says Marianne Brown, CEO of Omgeo, a firm that helps to affirm trades.

Madoff's tightly run firm — which treats employees and their families to a weekend outing each year at his oceanfront home in Montauk, N.Y., the easternmost point of Long Island — was the sixth-largest market maker for Standard & Poor's 500 stocks this year through October, executing trades on $1.86 billion of shares, SEC data show.

Madoff also is credited with creating a vibrant market for small investors by helping lower the cost of trading, which led to firms such as E-Trade, Ameritrade and Charles Schwab in the 1990s.

Homes in New York and Florida

He lived well. He has an expansive prewar co-op on Manhattan's Upper East Side, real estate records show. An apartment similar in size to his unit sold for more than $5.7 million in 2006. In addition to his Long Island home, he has a waterfront home in Palm Beach and a 55-foot yacht there named Bull, Florida records show.

He was politically active, donating $25,000 a year to the Democratic Senatorial Campaign Committee as well as recent races by New York Sens. Charles Schumer and Hillary Clinton and New Jersey Gov. Jon Corzine. Madoff has also been an active donor — through the Ruth and Bernard Madoff Foundation — to New York philanthropies including The Doe Fund and Girls Inc.

Many were stunned that someone so prominent could commit such a massive alleged fraud. "It's like you find out the Tooth Fairy died," says Robert Battalio, professor of trading at University of Notre Dame's Mendoza College of Business.

The end came after Wednesday when, according to the SEC complaint, Madoff told two unnamed senior employees that his fund was "all just one big lie" and "finished" with "absolutely nothing." Madoff allegedly said that he still had as much as $200 million that he wanted to distribute to family, friends and employees— for example, paying bonuses two months early — before he turned himself in. The employees alerted authorities.

His arrest was "a shocking development," Fairfield Greenwich Group, a firm that directs investors to hedge funds, said on its website. It added that it's "working with counsel to assess the situation and take all steps necessary and appropriate to protect our investors and the firm."

But others were skeptical. "Bernie's results were just too unbelievable," says David Henry, an executive of a private company that invests in hedge funds. "He rarely had any negative results. It didn't make sense. He had regular returns of about 10% for years. It was like finding the Holy Grail."

Madoff said much of his success was due to a strategy called "split strike conversion" that used a combination of stock options to enhance the upside and limit the downside of a basket of stocks.

But Jeremy Bach, a Philadelphia-based consultant who helps investors evaluate fund managers, says he helped conduct a 2005 analysis of Madoff's results. "We were not able to identify a single factor that was driving the returns," says Bach.

Michael Ocrant wrote a story in 2001 for MARHedge, which covers the hedge fund industry, about how some traders, money managers and financial consultants questioned Madoff's record of 72 winning months in a row. "When I spoke to them about something not being right … they were adamant — there's no way this could be real," says Ocrant, now at Institutional Investor. "There's no one in history with that kind of results." He says Madoff smoothly dismissed the questions when he interviewed him at the time. "You could see why people would trust him, particularly since he'd been running a successful business for years."

Routine regulator questions

Regulators' questions were fairly routine and centered only on the broker-dealer business. The SEC completed an examination in 2005 that resulted in three violations of "best execution" rules. The SEC also completed an investigation in 2007 that did not include any referral for enforcement action. The Financial Industry Regulatory Authority took five disciplinary actions against the firm since 1975, according to filings, the most recent on Aug. 27, when it accused the firm of not reporting accurate trading information. The firm was fined $25,000 and didn't admit or deny the findings of the action.

But it was the other part of Madoff's firm — the advisory investment management unit — that was at the heart of the alleged scandal. And there was little oversight of that business until Sept. 12, 2006, when it was registered with the SEC.

Investors didn't seem to care. Marketers of investment funds told potential clients that part of their money would be put under Madoff's care if they invested in four relatively unknown funds.

"Madoff was the carrot to get people in other funds," says Jon Najarian of option trading research firm OptionMonster. Meanwhile, current investors with Madoff were nervous to pull their money out, fearing they wouldn't be able to get back in later.

The stickiness of investor funds gave Madoff a pool of cash to play with until the redemptions hit amid the credit crunch. "He was a brilliant marketer in an evil way," Najarian says.

It all started to unravel, according to the SEC complaint, in the first week of December when investors asked for $7 billion in redemptions. That was the one variable Madoff couldn't mitigate.

The alleged Ponzi scheme lasted so long and became so huge because of Madoff's sterling reputation, says Barry Minkow, co-founder of the Fraud Discovery Institute, who served time in prison after defrauding investors as founder of ZZZZ Best. "It's always the last person you'd expect."